High risk, high reward? Understanding how sectoral and thematic MFs work

Mutual fund investors often look for opportunities to increase portfolio returns, and sector and theme-based funds provide an option to do just that. These funds focus on high-growth sectors or investment themes, providing potential diversification. However, while their returns can be attractive during favorable market cycles, they come with increased risks and cyclical volatility. To help investors navigate this space, ET spoke to Smart Investor Chirag MuniAt the Executive Director Anand Rathi wealth. In this special edition, we decode the noise of sectoral and thematic funds, explore their recent performance and discuss key factors to consider before investing. Quotes:

What is the main difference between sectoral and thematic funds?
Chirag Muni: Sectoral funds focus on investing in specific sectors such as pharma, IT or banking. Thematic funds, while similar, are broader, revolving around an investment theme. For example, a defense theme may include manufacturing, technology, and other related companies. Sectoral funds are narrowly focused, while thematic funds allow greater diversification in concept.

performance
How have thematic and sectoral funds performed recently and why were many thematic funds negative last quarter?
Chirag Muni:: Some funds performed spectacularly in the last one year. For example, HDFC Defense Fund returned 77%, while LIC MF Infra Fund and Bandhan Infrastructure Fund returned 69% and 65% respectively. However, in the last three months, market volatility has affected these funds significantly, with sectoral funds witnessing losses of up to 11% against a 3-4 percent decline in diversified equity funds. Their concentrated nature makes them more susceptible to market swings.

Risks associated with Sectoral and Thematic Funds

What are the risks investors face with sectoral and thematic funds?
Chirag Muni: There are mainly two risks associated with these two funds:

Cyclic performance: Sectors move frequently – what is prosperous one year may underperform the next. These funds are highly cyclical, requiring strategic entry and exit strategies, which may not suit regular investors. A common mistake is to invest based on past performance, which misses out on future opportunities.

Lack of diversification: Focusing on one sector or theme increases risk if that sector underperforms.

What is the difference between Diversified vs Sectoral/Thematic?
Chirag Muni: Diversified equity funds like flexi cap funds perform better over time due to their reduced risk and broader market exposure. For example:

Flexi Cap Funds: 37.48% YTD (2024).

Financial Sector Funds: 26.53% YTD (2024).

Which sectors have excelled recently and what are their future prospects?
Chirag Muni: PSUs have performed well in the last two years due to stable governance and potential disinvestment opportunities. Looking ahead, the infrastructure sector shows promise, supported by significant budgetary allocations from the government. Banking is also set to benefit if infrastructure is developed.

Ideal investors for sectoral and thematic funds

Who should invest in these funds?
Chirag Muni: Sectoral and thematic funds are suitable for discerning investors who actively track markets and sectors. For high-risk investors, they can make up 5-10% of the portfolio. Low and moderate risk investors should focus on diversified equity funds. Timing is critical, as holding on to underperforming sectors can significantly impact returns.

Strategies for different risk profiles

What are your recommendations for low, medium and high risk investors?
Chirag Muni: sure

Low risk investors: Choose large-cap funds with stable returns from top 100 companies.

Medium Risk Investors: Choose multi-cap or flexi-cap funds for balanced exposure to large, mid and small-cap stocks.

High risk investors: Allocate 10-12% to sectoral or thematic funds like SBI Infrastructure Fund, while keeping the majority in diversified categories.

Watch the full interview here

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